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How can we avoid Highly Compensated Employee (HCE) refunds?

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Employers can take proactive and retroactive steps to reduce the likelihood of HCE refunds due to nondiscrimination testing failures. Some strategies require changes before the testing period, while others may help correct issues after a failure occurs.

Proactive Strategies (Before Nondiscrimination Testing Fails)

  1. Adopt a Safe Harbor 401(k) Plan – Safe Harbor plans are exempt from Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) testing by requiring employer contributions, such as:
    • Safe Harbor Match: A required employer match, either basic (dollar-for-dollar up to 3% and 50% on the next 2%) or enhanced (at least a 4% match on all deferrals).
    • Safe Harbor Nonelective Contribution: A 3% employer contribution to all eligible employees, regardless of their deferrals.
    • Qualified Automatic Contribution Arrangement (QACA): A type of Safe Harbor plan with automatic enrollment and a graded match structure.
  2. Important: Switching to a Safe Harbor plan requires a plan amendment before the start of the plan year. Employers cannot retroactively adopt Safe Harbor provisions to fix a failed test.
  3. Encourage Higher NHCE Participation – Increasing contributions from NHCEs helps balance the deferral percentages between HCEs and NHCEs, improving test results. You may consider:
    • Automatic enrollment to have higher participation from employees.
    • Employer matching incentives to encourage NHCEs to contribute more.
  4. Monitor Contributions Throughout the Year – Conducting a mid-year nondiscrimination test can help identify potential failures early. Employers can then adjust contribution strategies, such as limiting HCE deferrals or increasing NHCE participation.

Retroactive Solutions (After an ADP or ACP Test Failure Occurs)

  1. Issue Refunds to HCEs – If the plan fails, the most common correction is to return excess contributions to HCEs, reducing their deferral percentage to a passing level. These refunds must be processed within 2½ months after the plan year-end (or 12 months with a 10% excise tax penalty).
  2. Make QNEC or QMAC Contributions to NHCEs – Instead of refunding contributions to HCEs, employers can make Qualified Non-Elective Contributions (QNECs) or Qualified Matching Contributions (QMACs) to NHCEs. These additional contributions help balance nondiscrimination test results and must be fully vested.
  3. Adopt a Retroactive Safe Harbor Nonelective Contribution – While employers cannot add a Safe Harbor match retroactively, they may be able to adopt a Safe Harbor Nonelective Contribution mid-year. This requires a plan amendment and a 3% minimum contribution to all eligible employees. If adopted after the plan year but before testing is completed, the required nonelective contribution increases to 4%.
  4. Consider a True-Up Contribution – If contributions varied throughout the year and their employer match was based on per-paycheck contributions, a true-up contribution can correct any missed match amounts. This helps ensure that all employees receive the full match they were eligible for, which may improve nondiscrimination test results.

By implementing proactive strategies, employers can reduce the likelihood of failing nondiscrimination tests. If a failure occurs, retroactive solutions can help correct the issue while keeping the plan compliant.